Looking abroad: local government airline subsidies

Rising incomes have positioned China as the world's largest source of outbound travellers, prompting Chinese cities to ramp up support for local flight routes. Much of this activity has been geared at launching long-haul flights, in order to attract more international tourists and foreign investment. However, strong reliance on subsidies to make these routes profitable and a broader lack of policy co‑ordination between regions pose high risks to the future development of the aviation industry.

Local governments have ramped up their efforts to enhance their air transport connections, based on the strategy that better air links would raise the profile of smaller cities and attract more tourists. In addition, they would deepen foreign investment through enhanced commercial links. Much of this support has come via local subsidies. In 2016 local officials spent at least Rmb9.6bn (US$1.5bn) to help local carriers launch new flight routes to popular overseas destinations, including London (UK) and Los Angeles (US), according to data compiled by Civil Aviation Data Analysis (CADAS), a Chinese aviation consultancy. The result has been an explosion in activity: in 2014‑17, Chinese carriers opened 78 new long-haul routes, compared with just 24 in the 2006‑13 period.

The central government has also lent policy support for some cities to add international flight routes, especially among those prefectures positioned strategically within the Belt and Road Initiative (BRI). Preferential policy support has also been granted to cities included in 19 city clusters identified in China's 13th five-year plan (2016‑20) for aviation development. In January‑August 2018 the Civil Aviation Administration (CAA), China's top aviation authority, received 78 applications for new international routes, mostly from major emerging cities in Central and Western China, such as Chengdu, Xi'an, Changsha, Qingdao and Kunming.

These subsidies have supported the rapid growth of China's aviation market, which has become well positioned to capture the demands of an increasingly mobile—and travel-hungry—middle class. In 2017 China's total airport passenger throughput reached 488m, second globally only to the US (823m), according to the International Air Transport Association, a Canada-based trade association.

Although most of China's airport capacity remains focused on serving domestic travellers, the number of tourists going abroad has skyrocketed, from roughly 41m annually a decade ago to over 130m in 2017. We expect China's middle class to account for 35% of the population (roughly 480m people) by 2030, meaning that demand for both domestic and international travel will remain stable over the next decade.

Mixed results

Government subsidies are an important fixture in the industry (and are common for the aviation industry globally). Annual reports of the eight listed Chinese airlines suggest that the subsidies they received in 2017 accounted for 43.5% of their total profit (Rmb28.9bn, or US$4.4bn) over that period. Within that figure, however, half the profits earned by these carriers were in turn dedicated to launching long-haul international flights, rather than short-haul domestic connections. This prioritisation may be the result of a mixture of corporate strategies and government priorities: local air carriers may view long-haul routes that service larger cities as more profitable based on higher demand and passenger volume, while local officials would want to enhance the international connections of their jurisdictions to drive investment and tourism, or for reputational reasons.

The results of this strategy to prioritise long-haul flights, however, have been mixed. The Chengdu-San Francisco (US) route started by United Airlines (US) in 2014, which has consistently had capacity rates above 80%, was positioned to meet the growing needs of multinational corporations setting up branches in western China, following the flow of investment (and talent) away from China's coast and towards inland regions—a trend that has strengthened over the last decade. The Chengdu-Shenyang-Vancouver (Canada) route, launched in 2016 by Sichuan Airlines, capitalised on an emerging trend whereby a growing number of residents from north-east China were choosing to study, work or live in Canada. By contrast, some routes are severely underutilised: in 2017 China Eastern's Qingdao-San Francisco route received a subsidy of Rmb120m (US$18m) from the Qingdao government, but on average flights on this route regularly had less than half of the seats filled.

Hainan Airlines, China's fourth-largest carrier, has been the most aggressive in establishing international flight routes, despite the well-publicised financial difficulties of its parent company, HNA Group. In January‑August 2018 Hainan Airlines submitted 43 long-haul route applications to the CAA, accounting for over half of the total applications filed in the same period. Its ambitious goals, however, underline a generally solid commercial performance by the company: Hainan Airlines posted net profits of Rmb3.3bn (US$500m) in 2017, despite generally receiving fewer subsidies than the three state-owned Chinese carriers that dominate China's passenger traffic (Air China, China Southern and China Eastern).

However, government policies are not always aligned with corporate strategies. New long-haul routes that have opened in China's smaller cities often lure passengers who would have otherwise travelled to—and flown from—airports servicing larger cities. However, China's three state-owned companies are often unable to justify the costs of servicing these smaller airports, allowing smaller, private carriers to capture these customer segments and steadily increase their market share.

Although this situation has led to more competition in the market, it has also ultimately prompted China's three largest carriers to petition the State Council, China's cabinet, to restrict local governments from issuing subsidies for long-haul flights (with these actions mostly targeting Hainan Airlines). Strong connections between HNA Group and the Chinese government, however, ensured that a government policy response to these petitions never materialised. But even in this case, rapid expansion of long-haul flight routes has also helped to drive down the profits of Hainan Airlines, which averaged only a 75% capacity rate in 2017—lower than its capacity performance in previous years (and the global industry-wide average of 81%).

Risks to future development

China aims to build 74 new civil airports by 2020, mostly in key cities in central and western China. However, there are signs that enthusiasm for launching long-haul flights is starting to slow, particularly as policymakers realise that these routes are helping to send Chinese tourists abroad, but doing little to attract international visitors in return. China's deleveraging policy efforts and its larger campaign to tackle financial risk will also inevitably slow investment, which remains credit- (and debt-) dependent.

Ongoing tax reform, which generally reallocates more tax revenue to the central government, will further limit local policymakers' ability to provide subsidies to local carriers, disrupting the model which has fuelled much of the growth to date.

In the medium term, long-haul flights will not necessarily be the most profitable deals for Chinese carriers, either. Chinese regulators have already announced that air fares will be fully liberalised by 2020, which may lessen the incentive for carriers to operate costly long-haul flights without stronger subsidy support. In addition, global oil prices are likely to continue their upward trend, ramping up price pressures. Foreign airlines are already beginning to pull out of smaller cities: in 2016‑17 British Airways and United Airlines discontinued their Chengdu-London and Xi'an-San Francisco routes, respectively, while American Airlines will halt operation of its Beijing-Chicago route in October 2018.

Regional integration through city clusters will bring additional risks to the long-term plans of China's carriers. For instance, although the Jing-Jin-Ji initiative connecting Beijing, Hebei and Tianjin has improved transport links in that region, this has largely been through high-speed rail and road rather than air links, creating competitive pressure for airlines. Airports in Tianjin and Shijiazhuang have historically benefited by taking passengers from Beijing, but plans by Beijing's authorities to open a third international airport—the largest in the world—in the Daxing district in 2019 will eliminate the competitiveness of these regional hubs. Like many other developmental woes in China, the lack of policy co‑ordination is one of the largest threats to the future development of the aviation industry in the country.